What Square's First Day Tells Us About IPOs
As the shares of the mobile-payments company Square jumped an impressive 45 percent in their first day of trading on Thursday, I was reminded of my time as a portfolio manager, when preparations for new sovereign and corporate issues would be the catalyst for heated discussions with investment bankers.
The challenges involved in getting an initial offering right are multifaceted: It is hard to align incentives for the major players and investment bankers eager for fees have to worry about business relationships that extend well beyond the company and its long-term investors. Importantly, these complications also point to the need for companies to think boldly about IPOs and be more active, just as Google (now Alphabet) did in August 2004 with its rather unorthodox share offering.
Square's website says its goal is to “take care of your business anywhere.” Using accessible technology and engaging interfaces, its adoption has spread rapidly among small and even medium-sized businesses. I have even come across the company’s services in farmers markets and at amateur theatrical productions.
The Square IPO was eagerly anticipated because of the company’s growth and its potential. The offering was also of broader interest to start-ups and their investors, which have experienced a significant cooling in the scale and ambitiousness of IPOs.
It hasn’t been an easy process for the company or its bankers. Reflecting changing market conditions, the pricing ground shifted frequently -- and after much deliberation, the IPO was priced at $9, well below the last indicative range of $11 to $13. The shares surged by almost 70 percent soon after they started trading Thursday morning, ending the day $13.07, a 45 percent increase, even though stock markets generally were flat for the day.
The meaning of this price action will depend on who you ask.
Company insiders, though they are happy to have gotten their IPO done, will wonder about the money that they left on the table given how strongly the stock has traded up so far.
Where bankers come out will depend on how their fees are calculated, how they were positioned when the stock started trading, and who they favored in the allocation process.
Investors will be very happy, including those short-term traders who realized a very profitable flip (that is, lacking a long-term commitment to the company, they sold their IPO allocation on the first day at a considerable profit).
This range of reactions reflects a more general issue. Given how the vast majority of new issues are handled, divergent interests need to be reconciled by investment bankers who themselves have a large stake in the IPO's performance. And their interests aren't necessarily always aligned with those of the major long-term stakeholders (that is to say, the company and its committed investors).
From my own experience participating in other new corporate and sovereign issues as a portfolio manager, and as a long-term investor, a good outcome has three important characteristics:
First, the new issue is anchored by a set of long-term institutional investors who are knowledgeable about the fundamentals of the company and its business, and are eager to become even more involved over time in supporting a successful investment.
Second, the rest of the book and its allocation are dominated by a diversified set of investors, who also have relatively longer investment horizons (that is, more than just a few days and weeks).
Third, the new issue trades slightly higher post initial pricing, consolidating gains without the type of large volatility that subsequently attracts an even bigger number of day traders and other short-term players interested only in flips (via both going long and going short).
Companies' management can play a large role in delivering such an outcome, especially if they are willing and able to press hard to determine the pricing of IPOs and other new issues -- that is to say, extending their involvement to include the "how," together with the “when” and “what.”
As Google demonstrated when it went public 11 years ago via an unorthodox pricing approach, such involvement can significantly improve the odds of delivering a successful and fair IPO.
Having looked at the analytics of IPOs, and confidently resisted pressures from investment bankers, Google opted for a “Dutch auction” that allowed both institutions and retail investors to place orders on the web. Rather than tailoring their interest in response to a predetermined price, these investors were able to declare their own price preference, committing to purchase a number of shares if the auction as a whole cleared at that price or one that was more advantageous. The new issue was then priced at the highest level that accommodated the total amount that the company indicated it would sell,
Given that this approach deprives investment bankers of large fees, it is not surprising that it hasn't caught on. But this doesn't mean that start-ups that decide to go public, and their long-term investors, have no other tools available to them.
Indeed, leaving the modalities of an offering only to investment bankers can be short-sighted in some cases, especially as many of the bankers come to the process worried about the range of profitable business relationships they already have -- and are interested in nurturing -- with short-term investors (particularly among hedge funds).
Companies themselves must get a lot more involved in how their IPOs are priced. If they cannot impose a change in the conventional pricing methodology, it is paramount that they seek to pursue a continuous set of checks and balances on the way the bankers build the book and allocate the new issue among potential buyers. In doing so, and given the incentives to overstate demand in what may be a successful IPO (as well as the incentive for fee-hungry bankers to “upsize” new issues at the last minute), companies also have to work especially hard to distinguish what investors say they are willing to buy from how much they actually would buy.
Long-term investors can also do their part to ensure that the IPO is solidly anchored. With a good understanding of the company and the sector, they can even make their own involvement conditional not just on price and timing, but also on the approach to constructing the book.
Diverging interests, misaligned incentives and competing initial conditions often make delivering a successful IPO a lot harder than many expect. It certainly shouldn't be left exclusively to the investment banks. Companies and their long-term investors should seek to play a larger constructive role. That also would contribute to better functioning markets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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